Blockforce Capital July Digital Asset Commentary

Key highlights

• Global assets were relatively unchanged in July, while bitcoin was down about 6.8% for the month.
• The floor of the Chinese Yuan was removed by the Central Bank of China, causing the currency to fall about 7% while bitcoin rose in tandem.
• Digital asset volatility may stay elevated versus its peers, even as the asset class gains mainstream adoption as the general nature of an asset trading 24/7 leads to five times the amount of data in a given week versus traditional stock markets.
• CME bitcoin futures volume has fallen considerably since June, but open interest remains on a healthy upward trajectory.
• The premium between CME futures pricing and spot currency rates has spiked from relative parity to up to as much as 3% for the month of July, indicated continued buying interest in the asset class in the midst of the falloff in liquidity.
• Ethereum continues to underperform bitcoin, and the standard deviation of the residual spread between the pair of assets continues to widen, indicating further drift between bitcoin’s strength and ethereum’s weakness in price as of late.
• Altcoins continue to underperform bitcoin, as BNB and LTC are the only two in the top ten that are outpacing bitcoin year-to-date. For the month of July, bitcoin was down 6.8% while the top alts were down around 20%.
• Volatility continues to remain at elevated levels not seen since February of 2018
• Year-to-date Sharpe ratios lose ground due to the market selloff, but they still remain elevated versus traditional assets.
• Bitcoin’s network activity, both in terms of average active addresses and daily transactions, continues to show healthy growth and has outpaced the metrics seen in January of 2018. Ethereum has shown positive momentum but is still outpaced by the action seen at the beginning of 2018.
• Spot market volumes on both Coinbase and Binance continue to grow. Binance’s monthly volume is up 47% since year-end and set a new high, while Coinbase has seen healthy volume growth but remains underwater from its record-setting December 2017 volumes.
• Bitcoin’s dominance continues to move higher and is now above 70%.

Market overview

Global assets were relatively unchanged in July, with bitcoin being the largest performance detractor at -6.8%. This muted performance across the board hides many important macroeconomic events that transpired in July, including:

• The first Fed rate cut since the 2008 financial crisis;
• The up-tick in negative bond yields across many developed countries;
• US equity markets teetering near all-time highs;
• Continuing China/US trade war;
• Ongoing regulatory scrutiny of Facebook’s Libra; and
• Continuing lower than targeted inflation rates across the board.

Broader markets priced in the Fed rate cut but were caught off-guard when Jerome Powell poured water on the expectation of further rate cuts this year. Traditional markets sold off at month-end while bitcoin experienced positive momentum after the news. It is challenging, however, to decipher precisely what is the main driver of crypto traders’ bullish sentiment. We believe the factor most likely driving the increased interest in bitcoin is either the deflationary aspect of the largest cryptocurrency as a global hedge or cheap borrowing costs for the speculative asset class, or perhaps both. This dual-narrative will continue to persist around cryptocurrency until the asset class is tested in a global recession.

Chinese Yuan and Bitcoin

There has been much speculation recently about the impact of Chinese investors on bitcoin prices. On August 5th, China’s central bank lowered its daily reference rate of the Yuan, removing the floor that had been set to prop up its exchange rate. The Yuan fell approximately 7% against the US Dollar, and bitcoin’s price rallied a similar amount over the same time period.

The chart below shows the prices of bitcoin and the Chinese Yuan versus the US Dollar as well as the rolling seven-day bitcoin and Yuan correlation (utilizing 30-minute data). The pair continues to show an insignificant statistical correlation (between +/- 0.10). While we believe the decrease in the value of the Chinese Yuan did inflate the price of bitcoin in May, and again in August, there are too many outside factors influencing the price of both assets for a correlation to appear at this time. The relationship will bear watching as the US trade war with China continues to heat up, and China wrestles with managing both its export industry and offshore capital flows.

Einstein’s General Theory of Relativity

Crypto time versus stock market time and its impact on performance and risk

In a typical week, the US stock market is open 9:30 a.m. to 4 p.m. ET Monday through Friday. That’s 32.5 hours of trading per week versus the 24/7 nature of cryptocurrencies which totals 168 hours per week, more than five times the trading hours of traditional markets. If cryptocurrencies were correlated to the S&P 500, one would expect the price action and volatility to mirror the S&P 500, which would mean that on a daily basis, cryptocurrencies would be less volatile than equities because the day’s price movement would happen over 24 hours, versus 6.5 hours each day. However, cryptocurrencies are not correlated to equity markets and, on average, have eight times the volatility of the S&P 500.

Digital assets move quickly as shown by increased volatility versus other global assets. In any given week, digital assets see as much as five times the amount of trading activity versus traditional markets. Consequently, when comparing the performance of traditional investment vehicles with digital asset investments, it’s essential to consider the factor of five — e.g., three months of price data and performance of digital assets equates to 15 (fifteen!) months of performance in traditional assets. Bitcoin has been around for over ten years and has had active pricing since mid-2010, giving us just under nine years of data. But after applying the factor of five, those nine years of bitcoin data represent the same amount of data in approximately 46.5 years of the S&P 500 trading market, or nearly half the time since the index was established.

We can look at this yet another way and draw an interesting, slightly far-fetched analogy with astrophysics. Einstein’s General Theory of Relativity predicts the existence of black holes. Black holes are places in the universe that have gravity so strong that not even light can escape. Einstein’s theory predicts (and actual experiments have verified) that time passes more slowly near regions of such intense gravity, and faster the farther away you’re from such areas. In this astrophysical sense, traditional markets may be orbiting a black hole, while digital assets have taken off, and broke free from the black hole’s gravitational pull.

The always constant availability of bitcoin liquidity may also poke holes in the theory that volatility of digital assets will continue to dampen over time to what is considered a “normal” trajectory as technology or an asset goes through the Gartner Hype Cycle. As assets become more mature, the volatility and risk decrease to normal levels. While we do believe digital asset volatility will decrease over time, it’s hard to fathom that it will fall far enough to be in-line with the established traditional markets like equities, bonds, or gold. The global 24/7 trading environment may always lead to periods of short-term elevated volatility due to liquidity and other global factors.

Furthermore, about 57% of the S&P500 volume comes from the first and last hours of the trading day, leaving light liquidity to add to price fluctuation throughout the day. Bitcoin’s volume is influenced by the sun, as there are often volume spikes at the day’s beginning within each major region. However, this phenomenon is more random than with traditional equity markets. That randomness and periods of light volume throughout the day are going to contribute to bitcoin’s continued elevated volatility.

Futures volume

June was a record-setting month for the institutionalization of the digital asset class, both in terms of global media coverage as well as futures open interest and volume. June 26th marked the peak in terms of bitcoin’s price year-to-date and CME bitcoin futures volume surged toward the month-end expiration, with almost $1.6 billion exchanging hands on June 26th, dwarfing May’s historic high of $543.2 million. Open interest peaked on June 24th at $309 million, 24% higher than the previous high set on May 31st. CME futures volumes were relatively muted in July, averaging about $20 million in daily liquidity and $65 million in open interest. The significant drop-off in volume is a small cause for concern, as futures volume has continued to show growth year-to-date, but the open interest remains relatively healthy. Furthermore, like most futures contracts, both volume and open interest usually climb into the quarterly expiration — currently set for the end of September, so we would expect this to continue to grow into the end of summer.

Another interesting development is the premium price of the CME bitcoin futures contracts versus the Bloomberg bitcoin spot rate. Futures were trading in relative parity with bitcoin’s spot rate until May and have jumped up considerably in July. Futures discounts or premia often dictate which side is providing an unbalanced amount of volume on the exchange. June kicked off with a slight but insignificant premium which carried through for the first three weeks of the month. The final week of June saw bitcoin’s price pop from $10,855 on June 23rd to a high of $13,796 on June 26th before falling to $10,799 by month-end. Over the same time-frame, the futures premium fell to parity. July volumes have been substantially lower than at the end of June and the futures premium popped 2–3%, which indicated a decent offset of buying interest.

ETH/BTC deviation

We have noted in prior commentary about the residual spread divergence/convergence between the two largest cryptocurrencies by market capitalization — Ethereum and bitcoin. There have been four events year-to-date where the spread has drifted outside two standard deviations. This happened again in mid-July, but this time bitcoin continued to support its relative price to Ethereum, while Ethereum continued to falter. There has been a lot of discussion surrounding the upgrade of Ethereum to improve the network, but it appears there has been a fundamental breakdown as the standard deviation continues to widen as the spread continues to drift lower.

Altcoin performance comparison

Binance Coin (BNB) and Litecoin (LTC) are the only two digital assets in the top ten by market capitalization that have outperformed bitcoin year-to-date, with BNB leading at +364%, followed by Litecoin at +214%, and bitcoin in third place at +168%. Ripple (XRP) and Stellar (XLM) are the only two assets in the top ten with negative year-to-date returns, down 13% and 26%, respectively.

Most digital assets had a parabolic upward move from April 1st through June 26th, with seven of the top 10 digital assets up more than 100% and three up more than 200%. Digital assets shifted to a downward trend in July, with many of the top 10 assets experienced a considerable drawdown since the June 26th peak, and eight of the top 10 losing more than 30% of their value, peak-to-trough. Furthermore, bitcoin did well to recover from its 27.7% July drawdown, posting a -6.3% monthly return, outperforming the other top digital assets for the month.

Volatility spike

It is our view that bitcoin continues to be the most favored of digital assets and the institutionalization of the asset class is the driving force for an allocation to the top cryptocurrency. The elevated volatility seen in July is reminiscent of early 2017, and the extreme price swings continue to offer enhanced return potential for active portfolio management. Since mid-June, bitcoin’s 60-day rolling volatility has been at a level not seen since February 2018 when most digital assets lost 50%+ of their face value. Bitcoin’s average 60-day volatility during the month of July was 99.5%, well above its long-term average of 77%.

Sharpe Ratios continue to fall, but beat traditional assets

As one would expect in a turbulent downward trending environment, the year-to-date Sharpe Ratios of top digital assets continued to decrease with Stellar (XLM) now negative on the year. Binance Coin (BNB) was once again the only top altcoin ahead of bitcoin in terms of Sharpe Ratio.

It’s important to note that even with the enhanced risk in this speculative market and general downtrend over the last month and a half, the risk/reward ratio continues to stay substantially ahead of many of its global asset peers. When looking at this ratio since 2017, a period in which bitcoin ran up 1000% in 2017, down 70% in 2018, and up 168% year-to-date, a long position in bitcoin beats every other asset class from a risk/return perspective. Bitcoin’s Sharpe Ratio is 1.5 while the next best risk asset is the S&P 500 with a Sharpe Ratio of 1. As we highlighted last month, a small (1–3%) allocation to bitcoin substantially enhanced a portfolios’ risk-reward ratio.

Blockchain activity

It’s also apparent in the underlying network activity that bitcoin has healthier support from both a transaction and an active address perspective. Circle Research released a report in late July that showed active addresses for bitcoin were 20% off from their December 2017 peak while active addresses for Ethereum were 41% off from their December 2017 peak.

Source: Circle Research

Average daily transaction count has an even more significant dispersion, as bitcoin’s transaction count for July was about 350,000, a 20% increase from January 2018 and 27% increase year-to-date. Ethereum is struggling in comparison, as there were approximately 1.1 million transactions in January 2018 versus 775,000 transactions in July 2019, a 30% decrease. While it’s less than peak levels, Ethereum’s 32% year-to-date growth is equally notable. The dispersion of the network activity highlights a similar trend of price performance, as both assets have substantially increased in value year-to-date but bitcoin’s 175% YTD performance through July outshines Ethereum’s 64% return over the same period.

Source: Circle Research

Correlation

As previously noted, bitcoin has outperformed most other assets year-to-date, and the correlations of top coins versus bitcoin had been drifting lower across the board before picking up in July. In traditional assets, correlations tend to drift lower during market upswings and increase sharply during downward trending moves as assets are sold in “risk-off” events.

Bitcoin spot market volumes

We noted the July drop-off in CME futures volume but the spot market volumes did not follow the same trend. In fact, both Binance (vs. USDT) and Coinbase (vs. USD) saw a healthy month-over-month increase of 16% and 17%, respectively. Binance’s monthly bitcoin volume has grown 47% since year-end and is 18% above its prior monthly peak set in December 2018. Coinbase is still 33% underwater from its historic high set in December 2017 when almost ₿1.1 million exchanged hands. The continued health of spot market volumes for the largest cryptocurrency is a healthy sign of ongoing participation.

Bitcoin dominance

We noted last month that Bitcoin’s dominance has been accelerating through June, and it continued in July as it closed the month representing 67% of the total cryptocurrency market capitalization. As of August 8th, it has continued to increase and topped 70%, a dominant metric not seen since July 3, 2017, a period where there were few altcoins and pre-dating Binance, the most popular cryptocurrency exchange by volume. This continued trend supports the notion that new entrants are grabbing ahold of bitcoin while altcoins have relatively been left for dead. It is a positive sign for bitcoin’s continued growth of adoption as an asset.

Looking forward to the next month

Bitcoin took a breather in July, but is off to a good start so far in August. Annualized six-month volatility has been steadily holding above 100%, and with the extensive price moves as of late, we would expect this to remain inflated. The ongoing underperformance of altcoins and bitcoin’s dominance continue to be of focus, especially with Binance cutting off the US from its primary exchange to launch under a separate entity.

Tracking all the developments and market moves in July only leave us more excited to see how the rest of this month and upcoming months play out as well. If you would like to receive our monthly market commentary again next month, please sign up here.

The opinions and data presented herein are not investment advice and are for informational purposes only and should not serve as the basis of any investment decision. Information is given in a summary form and does not purport to be complete. Information and data have been obtained or derived from sources believed by Blockforce Capital to be reliable, however, Blockforce Capital does not make any representation or warranty as to its accuracy or completeness. The sole purpose of this material is to inform, and in no way is intended to be an offer or solicitation to purchase or sell any security, other investment or services, or to attract any funds or deposits. Past performance does not guarantee future results.

DISCLOSURE: Blockforce Capital manages investment vehicles that invest in and hold digital assets, including the digital assets discussed in this article.